The Pound declined against the Dollar and the Euro on mounting speculation that the Bank of England will need to engage in further asset purchases

Sterling / Euro and US Dollar exchange rates

Following on from last week, the Pound declined against the Dollar and the Euro on mounting speculation that the Bank of England will need to engage in further asset purchases beyond the £75 billion increase announced earlier this month, as the economic outlook continues to worsen. Reports last week have showed manufacturing continued to decline in September, while unemployment surged by the most in 15-years, as the government spending cuts dampen consumer confidence.

The deputy governor of the Bank of England Charles Bean was quoted in a newspaper interview, saying that policy makers could well decide to expand quantitative easing again over the coming months. The preliminary third quarter economic growth figures will be released this month and may show a contraction in growth during the three months to September.

The Pound declined the most against the Yen, as the threat of a recession and further quantitative easing undermined traders’ appetite for riskier assets. The Bank of England has noted “severe strains” in banking funding markets and the governor Mervyn King said the move was a response to possibly the worst financial crisis ever.

MPC member Adam Posen said earlier this month that the MPC “will readjust the plan if it turns out we need more.” While his colleague Martin Weale also said this month that the Bank has a “lot of scope” to increase asset purchases if it is deemed necessary to boost economic growth. UK output has barely expanded over the past twelve months, as the government spending cuts impacts households income.

UK gross domestic product is currently 4.4% below its peak level in the early 2008, which represents the weakest recovery for almost a century. Alistair Darling, the finance minister in the previous Labour government, warned of “a very long period of stagnation with tremendous cost to the country.” Until this month, Adam Posen was the sole voice for an increase in asset purchases since October last year.

The Pound declined even after a report showed the UK trade deficit narrowed in August, as exports rose to a record level and imports fell. The gap in trade shrank to £7.77 billion, from £8.15 billion in July. The previous month’s deficit was revised from a reported £8.92 billion. Exports rose 0.6% to the highest level since current records began in 1998.

Elsewhere, a separate report showed that a gauge of UK house prices fell for the first time in three months in September, as the turmoil engulfing financial markets spurred by the European debt crisis undermined confidence. The average price of a home in Britain fell 0.3% from August to the lowest level since June.

The Pound was able to consolidate above the 1.57 level against the Dollar on Friday and pushed to challenge resistance levels above the 1.58 level following the U.S data. The UK currency peaked close to a one-month high of 1.5850 before drifting weaker against the Euro. There was some concerns that any increase in INF funds to support the Euro-zone would require increased UK support for the IMF, which could further compromise budget targets.

There were some media reports surrounding the weakness in the Royal Bank of Scotland, which undermined market sentiment, as any further bailout for the UK banking sector would pose enormous risks to the government’s economic policies. There were further warnings over the economic outlook during the weekend, but Sterling was able to resist more than a limited correction.

UK economic data this week is expected to show that inflation is forecast to rise in the headline annual CPI rate to 4.9%, pushing it even further above the government’s 2% target. However, with growth fragile and the BoE loosening policy, the rise in inflation is unlikely to have a major market impact. The Bank’s dovish outlook on the economy will be emphasized in the MPC minutes, which are due on Wednesday.

Euro / US Dollar exchange rates

The Euro rallied against the U.S Dollar last week, as Slovakia finally passed the vote to extend the EFSF, while the single currency also gained against most of the majors, ahead of the G-20 meeting when finance ministers meet to discuss plans to tackle Europe’s debt crisis. The Euro recorded the first five-day gain in a month.

The Euro bounced back from an earlier decline as Spain’s credit rating was cut by Standard & Poor’s to AA- with a negative outlook. The nation’s rating has been lowered by S&P three times since 2009, when the country lost its AAA status. Spain has a jobless rate as high as 21% and the threat of contagion to other high deficit nations will continue to have an impact.

The Euro found support in the region of 1.3750 against the U.S Dollar and rallied back to test resistance levels above 1.38. European inflation was confirmed at 3% for September, limiting the scope for ECB action on interest rates. There was a further mood of cautious optimism surrounding attempts to find a solution to the crisis as officials continue to debate policy options.